Diversification and Position Sizing

Ways of Trading

If you are looking at long-term investment, then you will probably be best suited by finding a broker, as detailed above. However, if you are considering taking a more active role in your financial future, and spending some time trading, you need to know that there are other ways that you can become involved in the markets that may have particular advantages and disadvantages for your situation.

For instance, you may have heard of the term derivatives. This covers many different types of trading instrument, some of which involve the value of shares on the market. The common factor to all types of derivative is that you do not trade the actual stocks or shares, or other financial instrument, but you trade or bet on the value of it, and how that changes. In other words the derivative “derives” its value from something else, the reason for the name.

One of the often used trading tools in the UK is spread betting. Spread betting allows you to bet on the value of shares, indices, and many other financial values. Again, you do not actually own any shares when you spread bet, but the value of your trade varies in some relationship to the value of the shares. Another such common derivative is the contract for difference (CFD).

A note for US readers. The Securities and Exchange Commission (SEC) which governs much of the market action in America has at the moment a position that spread betting and contracts for difference should not be available to the trading public. There has been some talk and negotiation, particularly with large brokerages wanting to expand their business into the States, but so far no budging on their view.

Also note that if and when spread betting is allowed in the States, you will not have the great advantage that it brings to the UK and other countries, namely that any gains do not count towards taxable income. In the US, the government expects to receive taxes from gambling winnings the same as any other income. Of course, profits can be offset by gambling losses, but no-one starts trading intending to lose . . .

Derivatives also include other financial instruments such as futures, options, and swaps. You may remember that the global financial crisis was caused in large part because of “credit default swaps” on thousands of home mortgages. The common trait to all these derivatives is that they give more leverage or gearing to the money that you choose to use. This means when you take a trading position, you do not have to pay the full value of the subject of the trade. Yet if your trade is successful, you may profit in full, which effectively multiplies your winnings.

The other side to this equation is that if your trade is a loser, then you can lose more than you intended, and sometimes more than you originally staked. Nonetheless, as mentioned above no traders set out with the belief that they will lose, so trading with derivatives has become very popular.

Diversification

I mentioned in the stock discussion above different market sectors, and this is something which is very important in if you are investing a substantial amount. The study of it is called asset allocation, but really all it amounts to is not putting all your eggs in one basket. You see, it might be that energy is going well this year, so you decide to put your fortune in different energy companies. If you choose to invest everything in energy companies, you could be caught out if something happens in the industry, such as a breakthrough in alternate energy systems, a massive oil discovery in France, or some government actions such as heavy taxation which discourages energy usage, and causes the stocks to tank.

The answer to this is that you should not always expect to be invested solely in the top-performing industry, unless you are prepared to accept the risk that you may suffer an industry wide setback. You need to be diversified into different industries or sectors which necessarily means that some of your investments will not be increasing at the fastest rate. This is the price you pay for reducing your risk and having more stability in your portfolio.

The same thing is true when you are trading. If you focus down on individual stocks without considering the sectors they are in, you could find that the top performers you are identifying with technical analysis are all in related industries. Should you put most of your trading funds into that sector, again you could be caught out by events. Given the transitory and rapid nature of trading, with less time to consider fully what you’re getting into, it is possibly more likely that you will be caught mainly located in one sector, and this is something that you need to watch out for.

Position Sizing

A related topic talked about when you’re trading is “position sizing”, which is the amount or proportion of your funds that you put into any particular trade. Once again, no matter how sure you feel about the trade there is no way that you should be putting a substantial amount of your capital into one trade, or into several trades in companies related by market sector. One of the skills of trading in the markets is to learn not to lose too much, and this includes making sure that you do not risk more than you should.

It is common to think in terms of what is the worst that you could lose, as some methods of trading such as options mean that you lose your whole stake and others such as trading directly in shares simply see a reduction in value if the trade goes in the wrong direction. Then if you figure that, with regular trading, over the months you’re going to see some times when you have five or 10 losing trades in a row, you can work out how large an amount you want to put at risk. You might be surprised to learn that one rule of thumb says you should not risk losing more than 2% of your total account on any individual trade.

While it may take you longer to get rich if you limit your stake to this rule, if you follow it you are less likely to hit a run of bad luck and find yourself out of money before you make it.